Return on Equity (ROE) is the income before non-recurring items generated during a period, expressed as a percentage of the average shareholders’ equity over that period. In other words, it is the income generated by a company by employing its net assets (since shareholders equity = assets-debt = net assets). Therefore, ROE essentially measures how efficiently the management of a company uses its assets to generate income.
Of course, corporate policy does have an impact on the number. For instance, let’s say Company A generates $100 in profits and pays out 50% as dividend. It therefore retains $50 in the business, which is again employed to generate profit. And Company B generates the same $100 but pays out 80% as dividend. It therefore retains $20 in the business to generate additional profit. So company A could be growing faster than company B, because it is paying out less dividend.
A company generally doesn’t pay out more if it can reinvest fruitfully in the business for growth. Mature companies usually generate more cash than they need for growth. So they’re the ones that pay out regular dividends.
An ROE of 15-20% is generally considered good unless the company belongs to a capital intensive industry (like utilities for example), in which case, ROE could be a few points lower. But an ROE under 10 is generally not considered very good for any company.
While ROE is a good way to identify management efficiency, here at Zacks, we also have a number of other tools that can be combined with it to pick out winning stocks.
Topping that list is the Zacks Rank that uses a number of criteria including estimate revisions to determine which stocks are likely to appreciate in value in the near term. The system ranks stocks from #1 through #5 with the #1 signifying Strong Buy, #2 Buy, #3 (Hold), #4 (Sell) and #5 (Sell). It’s the #1 and #2 ranked stocks that have maximum upside potential.
Up next is the Zacks Industry Rank, which seeks to allot a rank to 250+ Zacks-classified industries, such that the higher the rank, the better performing the industry. It has been seen historically that 50% of a stock’s appreciation is related to the industry that it’s in.
Additionally, the top 50% of these industries have historically outperformed the bottom 50% by a factor of more than 2 to 1. So one should try selecting stocks in the top 50% of industries because these stocks have a better chance of outperforming the market.
We also have the Zacks Style Score system to classify stocks based on an investor’s risk appetite. So investors looking for safer bets would be looking at Value Scores or A or B, investors willing to take some risk in exchange for higher growth should consider Growth Scores of A or B. Momentum traders should consider stocks with Momentum Scores of A or B. The three scores are also averaged into a “VGM” Score. Companies with a VGM Score of A or B could be selected by any investor.
A company that has a high dividend growth rate and also an attractive ROE would make a great investment because its management is able to make efficient use of its assets while also taking care of shareholder returns. It’s also an indication that dividend income is not at risk.
But to be on the safe side, we should also consider the valuation.
Let’s take a look at some examples-
Boise Cascade (NYSE:BCC), L.L.C. BCC
This manufacturer and distributor of wooden and building products has a Zacks Rank #2, Value Score A, Growth Score A and VGM Score A.
It operates in the Building Products – Wood industry, which is in the top 28% of Zacks-classified industries.
It has an ROE of 25.51% (industry ROE 16.47%) and 5-year historical dividend growth of 45.19% (dividend yield is 0.94%).
Valuation: It has a price to sales (P/S) ratio of 0.33X (any value below 1 indicates that the company’s sales are undervalued). On a forward P/E basis, the stock trades at 12.84X, which is below its median value of 16.92X over the past 12 months. So the shares are worth snapping up.
RentACenter, Inc. RCII
The company offers durable goods such as consumer electronics, appliances, computers, furniture and accessories from a big range of leading brands on a rent-to-own basis.
It has a Zacks Rank #2, Value Score A, Growth Score A and VGM Score A.
It belongs to the Consumer Services – Miscellaneous industry, which s in the top 38% of Zacks-classified industries.
It has an ROE of 35.08% (industry ROE 7.81%) and 5-year historical dividend growth of 31.37% (dividend yield is 3.34%).
Valuation: It has a P/S ratio of 0.68X. On a forward P/E basis, the stock trades at 9.89X, which is below its median value of 10.37X over the past 12 months. So the shares are worth buying.
Kroger is known for the thin margins on which it sells groceries. The Zacks Rank #2 company has a Value Score A, Growth Score B and VGM Score A.
The Retail – Supermarkets industry to which it belongs is in the top 34% of Zacks-classified industries.
It has an ROE of 26.31% (industry ROE 10.81%) and 5-year historical dividend growth rate of 5.79% (its dividend yields 2.23%).
Valuation: It has a P/S ratio of 0.19X. On a forward P/E basis, the stock trades at 11.53X, which is below its median value of 12.51X over the past 12 months. So the shares are undervalued.
Polaris designs, engineers and manufactures off-road and on-road vehicles. It has a Zacks Rank #2, Value Score A, Growth Score A and VGM Score A.
The Automotive – Domestic industry to which it belongs is in the top 10% of Zacks-classified industries.
It has an ROE of 40.78% (industry ROE 9.78%) and 5-year historical dividend growth rate of 3.17% (its dividend yields 2.57%).
Valuation: It has a P/S ratio of 0.90X. On a forward P/E basis, the stock trades at 12.59X, which is below its median value of 14.23X over the past 12 months. So the shares are undervalued.
Silgan Holdings (NASDAQ:SLGN) Inc. SLGN
Silgan Holdings is a leading supplier of rigid packaging for consumer goods products. The company has a Zacks Rank #2, Value Score B, Growth Score A and VGM Score B.
The company operates in the Automotive – Domestic industry, which is in the top 2% of Zacks-classified industries.
It has an ROE of 29.13% (industry ROE 33.14%) and 5-year historical dividend growth rate of 9.11% (its dividend yields 1.35%).
Valuation: It has a P/S ratio of 0.83X. On a forward P/E basis, the stock trades at 11.73X, which is below its median value of 13.28X over the past 12 months. So the shares are undervalued.
Whirlpool Corp. WHR
One of the largest manufacturers of home appliances in the world, Whirlpool carries a Zacks Rank #1, Value Score A, Growth Score A, Momentum Score B and VGM Score A.
The Household Appliances industry to which it belongs is in the top 39% of Zacks-classified industries.
It has an ROE of 26.10% (industry ROE 19.81%) and 5-year historical dividend growth rate of 6.14% (its dividend yields 2.55%).
Valuation: It has a P/S ratio of 0.62X. On a forward P/E basis, the stock trades at 9.85X, which is close to its median value of 9.73X over the past 12 months. So there is scope for further upside.
Final Words
All except BCC and RCII have recently lowered their payout ratio as the pandemic has impacted their businesses. However, since management at these companies is efficient, estimates are moving up and other factors are pointing to a strong recovery, these stocks are looking good.
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